Fortunately, they have occurred at a time when growth was being supported in three ways: by high employment that boosts income and consumption; by high profits and strong company balance sheets that underpin investment and bring added resilience in the face of financial losses and tighter credit; and by still buoyant world trade driven by robust growth in emerging economies.So, although near-term growth has been revised down virtually everywhere in the OECD area, the baseline scenario presented in the latest OECD Economic Outlook is actually not that bad in view of the recent shocks (see table
). It represents the outcome that carries the highest probability in the current more uncertain situation and involves:
- Accelerated adjustment in the US housing sector that will drag down growth to low levels in the near term but will not trigger a recession and will only modestly push up unemployment. Over the next two years, inflation will revert to a more comfortable level and the recent fall in the external deficit will be preserved–in both cases despite high oil and commodity prices.
- A partial decoupling of euro area activity from that of the United States, with a limited near-term slowdown in the underlying rate of expansion at a time when capacity constraints were beginning to bite. Once immediate headwinds have faded, growth might return to potential, while headline inflation should ease to desired levels.
- A continued albeit weakened expansion in Japan, which remains driven by the external sector but will eventually lift the economy out of deflation, thereby heralding a more balanced growth pattern.
The trouble lies on the downside. The main risks include a more pronounced or generalised cooling of housing markets than projected; additional turbulence in financial markets; and further upward pressures on already high commodity prices. There are several areas where appropriate policy settings can help to deal with such risks. Thanks to well-anchored inflation expectations, a number of central banks have been able to respond flexibly to the recent financial turmoil, through providing liquidity to interbank markets as well as through lower than expected interest rates. Expectations of low inflation also help the adjustment to higher oil and commodity prices and allow for monetary policy to respond to cooling housing markets where necessary. Overall, this confidence that inflation will remain low, built up through a long and sometimes painful process of disinflation, constitutes a major policy asset. However, these circumstances cannot be taken for granted. Indeed, margins of slack throughout much of the OECD have shrunk markedly. Moreover, OECD economies have been hit by cost shocks: raw material prices have soared and, partly connected to this, the disinflationary effects of manufactured imports from China are fading. If signs emerge that inflation expectations are drifting up, it might be necessary to pay a price in terms of lower activity in the short term to preserve this vital policy asset. Turning to the fiscal side, public finance outcomes have tended to be better than budgeted in the recent past, mostly on account of buoyant receipts. Part of this revenue bonanza is likely to be temporary, partly reflecting high profits in business activities related to finance and housing. The impetus for fiscal consolidation seems to have already diminished as a result of these windfalls. The OECD projections, which are based on currently legislated or clearly announced policies, show no further progress in reducing the underlying OECD-wide fiscal deficit. This is regrettable, not least in view of expected future spending pressures. Further, there is a risk that some countries that cannot afford it will nonetheless take decisions that permanently raise spending or reduce taxes on the basis of temporarily high receipts. This could weaken the underlying budget position. Should the downside risks to growth subsequently materialise, such weaknesses could surface and prevent fiscal automatic stabilisers from working just when these are needed most. In other words, fiscal policy must stay on the straight and narrow, despite buoyant revenues.The financial model based on the origination of loans, their rebundling and securitisation, and subsequent distribution has enabled credit to flow to agents who might not otherwise have found it. At the same time, sophisticated financial instruments have allowed the associated risk to be allocated to investors willing to bear it. However, the model also has some deficiencies that have come out into the open with the collapse of the sub-prime market in the United States. One such deficiency is the lack of information as to where in the system various risks are concentrated. Moreover, the re-pricing of assets and recognition of losses now that the assessment of risk has changed is proving slow. The combination of uncertainty as to who holds risk and slow recognition of losses has caused liquidity to dry up in some markets.As long as the process of re-pricing and loss discovery continues, financial markets are likely to remain a source of uncertainty and therefore vulnerability to shocks. Hence, action to speed up the process would be useful. However, regulators and supervisors will need to balance the desire for a rapid restoration of confidence in balance sheets of financial institutions against the risk of triggering a severe retrenchment in credit supply. In due course, the lessons will have to be drawn as to whether and how the regulatory framework around the current model needs to change to prevent its malfunctioning in the future.
Countries have been, and will be, hit differently by financial turmoil and housing-related weakness. In such circumstances, the natural response of market economies includes a re-pricing of currencies. As long as such movements do not become a source of instability, they tend to facilitate the necessary adjustment process by redirecting demand to where it has fallen. Recent dollar depreciation is a case in point. The OECD projections rest on the assumption of unchanged exchange rates, but should downside risks over and above those that have already crystallised affect economies differently, this could well be accompanied by exchange rate adjustment. This could lead to concern about lower activity in countries facing appreciation and about higher inflation in countries witnessing depreciation.A striking feature as regards exchange rates is the so far limited appreciation of the renminbi. Given symptoms of overheating and high domestic inflation, faster appreciation would seem to be in China’s own interest. It would also contribute towards a narrowing of some of the current international payments imbalances.Timely and orderly exchange rate adjustments may also help alleviate protectionist pressures in OECD countries. These carry risks not just for trade but also for investment. Given the size of projected current account imbalances, a number of countries–not least oil producers–will be recycling large export earnings and will aim to boost the return on recycled funds by investing through Sovereign Wealth Funds or similar vehicles. Protectionist noises, whether in the trade or investment area, are not helpful for business confidence, especially at a time of significant downward risk. The best response would be progress in a multilateral setting, including on trade in the Doha Round and investment in organisations such as the OECD.~This article is based on the the editorial of OECD Economic Outlook No. 82, Preliminary Edition, December 2007. The sign-off date is 27 November 2007. See summaries, data and projections by clicking here. Order the full edition at www.oecdbookshop.org Outlook summary*
| ||2007 ||2008 ||2009 |
| || || || |
|Real GDP growth (% change) || || |
|United States ||2.2 ||2.0 ||2.2 |
|Japan ||1.9 ||1.6 ||1.8 |
|Euro area ||2.6 ||1.9 ||2.0 |
|Total OECD ||2.7 ||2.3 ||2.4 |
| || || || |
|Inflation** (%) || || || |
|United States ||2.6 ||2.1 ||2.0 |
|Japan ||-0.5 ||-0.3 ||0.3 |
|Euro area ||2.2 ||2.2 ||2.3 |
|Total OECD ||2.3 ||2.1 ||2.1 |
| || || || |
|Unemployment (%) || || || |
|United States ||4.6 ||5.0 ||5.0 |
|Japan ||3.8 ||3.7 ||3.6 |
|Euro area ||6.8 ||6.4 ||6.4 |
|Total OECD ||5.4 ||5.4 ||5.3 |
| || || || |
|Current account balance (% of GDP) || |
|United States ||-5.6 ||-5.4 ||-5.3 |
|Japan ||4.7 ||4.8 ||5.2 |
|Euro area ||0.2 ||-0.1 ||-0.2 |
|Total OECD ||-1.4 ||-1.4 ||-1.4 |
| || || || |
|Short-term interest rate (%) || || |
|United States ||5.3 ||4.6 ||4.7 |
|Japan ||0.7 ||0.6 ||0.9 |
|Euro area ||4.3 ||4.2 ||4.1 |
| || || || |
|World trade growth (% change) ||7.0 ||8.1 ||8.1 |
* Assumptions underlying the projections include:
" no change in actual and announced fiscal policies;"
" unchanged exchange rates as from 12 November 2007; in particular 1$ = 109.38 yen and 0.69 euros;"
the cut-off date for other information used in the compilation of the projections is 20 November 2007.
**Increase in GDP deflator
Source: OECD Economic Outlook, No. 82, Preliminary edition, December 2007
©OECD Observer No. 264/265 December 2007